Why Are There So Many Stock Exchange Scandals?

Summary:Since the turn of this century there has been something of a procession of stock exchange scandals and financial crimes. For us ordinary investors, they seem to be of a mammoth scale and have helped to erode trust in financial markets and the banks and organisations that operate within them.

A factor that has been associated with the stock exchange downturn and
bear market that accompanied the dot com crash was a series of revelations regarding the accuracy of
financial statements issued by corporations. This also questioned the
integrity of the independent public accounting firms that audit these
financial statements.

The most famous of these cases involved the Enron Corporation and Arthur
Andersen LLP, an accounting firm. Enron, an energy company that traded
in derivatives, engaged in a series of money-losing partnership
transactions that were not reflected in its financial statements.

Arthur Andersen, one of the largest accounting firms and the
auditor of Enron, overlooked these questionable practices, providing
credibility to Enron’s misleading financial statements.

The losses were finally revealed in the fall of 2001 when Enron
officials admitted that the company’s net worth had been overstated by
more than $1 billion.

As you might imagine, revelations like this casued the price of
Enron stock to fall from $83 per share in December 2000 to less than $1
per share in December 2001.

Arthur Andersen was convicted of obstruction of justice charges
in June 2002 in connection with its Enron activities. The loss of its
reputation as an independent auditor was even more telling, causing
Arthur Andersen to discontinue much of its auditing activity. Ken Lay of Enron was also convicted (of 10 counts) but passed away before sentencing forcing his sentence to be vacated.

Such massive frauds can only harm the image and standing of a stock exchange.

At the same time that the Enron scandal was being reported,
similar problems with financial statements were reported at a number of
other companies including WorldCom, Inc. and Global Crossing.

The accounting fraud uncovered at WorldCom proved to be the
largest in U.S. history. The company overstated its earnings by $11
billion, and its subsequent bankruptcy cost investors an estimated $200
billion. The United States DOJ brought criminal charges against
WorldCom’s former chief financial officer, and the SEC filed civil
lawsuits against former WorldCom executives.

Later, the conviction of Canadian (Lord) Conrad Black for many
misdeeds at Hollinger, showed once again that people of power at the top of organisations are prone to overreach, believing - it seems - that they are omnipotent.

The collapse of what seemed to be an
incredibly popular hedge fund run by Bernie Madoff, show that avarice
cannot be removed from the stock market by regulations. Unfortunately.

Madoff was sentenced to 150 years in prison after being convicted of 11 federal felonies after his 2008 arrest. The investment company he ran has been described as the largest ever Ponzi scheme and somewhere in the region of US$65 billion is believed to have been defrauded from investors.

Connecting the dots

More recently, the conviction of hedge fund manager Raj Rajaratnam for insider trading has helped prosecutors to a string of convictions. By tapping his phone, regulators were able to piece together a web of contacts that assisted and benefited from illegal trades. In total almost 100 convictions have been made.

A real problem for prosecutors is always proving motive. After all, if you have a net worth of $xx million, why risk it to earn another million? This question has been hard for normal people - like you and I - to come to terms with. Why risk prison for wealth if you are already incredibly wealthy?

Despite grappling with these issues, it seems that overconfidence and overreach are important, but dangerous, elements of the human psyche and stock market participants are just as prone to it (or perhaps even more so) than everyone else. It also appears that holding and using power are important motivators. This would seem to be an important element in the minds of hedge fund titans.